Why You Should Buy the Dip

 |  Includes: DIA, QQQ, SPY
by: Sean Hannon

Memory is an amazing asset. Living in a digital-age where new information constantly erupts, we often rely upon past experiences to synthesize and react to the never ending data stream. Doing so allows us to pierce the clutter and intelligently make quick decisions.

A natural approach, is relying upon memory wise? It depends. If the tools (the events being recalled) we are using are correct, all is fine. However, recall an event incorrectly and errors compound.
Examining the distinction between valid and misplaced memories, a 2006 study published in the Neuron Journal examined why some people remember more details of events than other people. The study found the brain does not use only one region to store memories, but must activate a particular brain area when the event occurs in order to help remember all the details of an event. As the study’s senior author Michael Rugg explains, “You can’t get out of memory what you didn’t put into it. It is not possible to remember things later if you didn’t pay attention to them in the first place.”

I stumbled upon this study when inventorying my past experiences. In particular, I was thinking of the Holiday season. Enter any grocery store or shopping mall and the Holiday season has begun. Despite there being 48 days until Christmas, the endless sales stimuli have begun.

Over the years, I have noticed this kickoff commencing earlier and earlier. No longer do we have a natural transition from Halloween to Thanksgiving to Christmas. Instead, retailers embark in a furious frenzy with the hopes of goosing sales.

Investors are experiencing a similar phenomenon. Last week was poised to follow a Halloween theme. An endless rally, overbought market, and three important catalysts converged with a sell-the-news outcome seeming likely. After all if any of the events were poorly received, investors would take recent gains and await better buying opportunities.

Logic did not prevail. Instead, Christmas came early. In rapid sequence, the Republicans gained control of the House of Representatives, the Federal Reserve (Fed) provided tremendous detail about its intention to purchase Treasury securities (QE2), and the October employment report blew past the consensus with an addition of 151,000 jobs as well as positive revisions of prior months.

Triggered by the trio of positive events, equity markets surged. The Dow Jones Industrial Average’s (Dow) 2.9% gain is impressive, but it is also indicative of broad market strength. Of the 14 international indices I track, 10 reached 2010 peaks last week and three others are an average of 2.5% from confirming these highs. As written in the most recent weekly market commentary, this broad strength reinforces the bullish theme and leaves us asking not when prices will fall, but how much further they can rally.

Having embraced the bull, we must prepare for weakness. The Dow and S&P 500 are the most overbought since the April peak (red arrows). Declining volatility displays increasing complacency. As investors are content riding the bullish thesis and believe all prices will continually march higher, the likelihood of a pullback increases.

If the pullback occurs, it is a buying opportunity. The broad confirmations witnessed last week do not guarantee future gains, but they rarely signal a market top. The trend is higher and weakness should be bought.